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Applying At-Risk Rules Risky

On remand from the Sixth Circuit, the Tax Court has held that a
deficit restoration obligation (DRO) added to the operating agreement
of a limited liability company didn’t allow its member to create
recourse debt. Despite the DRO, the at-risk rules under IRC § 465
barred a current deduction because the member wasn’t personally liable
for the repayment of that debt, the court said.

Hubert Holding Company (HHC) owned 99% of Leasing Company LLC (LCL),
a Wyoming LLC classified as a partnership for federal income tax
purposes. After LCL’s tax year ended on July 31, 2000, its operating
agreement was amended to state that on liquidation of the company its
members were required to satisfy the negative balances in their
capital accounts, thereby imposing a DRO on the members. The reasoning
for this amendment was that the effect of its DRO was to obligate the
members to contribute capital equal to their pro rata share of LCL’s
recourse indebtedness, thus creating an “at-risk” amount under section 465.

Under section 465(b)(2), a taxpayer is considered to be at risk for
amounts borrowed if the taxpayer is “personally liable for the
repayment of such amounts.” However, the Sixth Circuit, in analyzing
this provision, has previously applied an Emershaw standard
or “payer of last resort” test. (See Emershaw v.
Commissioner, 68 AFTR2d 91-5894 (1991)). Emershaw, among
other cases, considered whether the taxpayer realistically had a fixed
and definite obligation to use personal funds to pay a debt in a
worst-case scenario. Under this test, if a taxpayer is deemed to be a
payer of last resort, the taxpayer is considered at risk for purposes
of section 465.

In its remand decision, the Tax Court held that HHC was not a payer
of last resort of LCL’s recourse debt and therefore not personally
liable for the repayment under section 465(b)(2)(A). According to the
Tax Court, HHC did not make an unconditional promise to
contribute additional capital to LCL, because the DRO required HHC to
contribute additional capital to LCL only if (1) HHC
liquidated its interest in LCL and (2) had a deficit in its
capital account at the time of liquidation. Thus, the operation of the
DRO hinged on the liquidation of HHC’s interest in LCL, and, under
Wyoming law, a creditor of LCL had no right to recover funds directly
from HHC or to compel a liquidation of HHC’s interest in LCL to force
a payment under the DRO.

The Tax Court further noted that the DRO did not require LCL to pay
the restored deficit to creditors. In fact, under the terms
of the LLC operating agreement, the DRO could be paid to members with
positive balances in their capital accounts rather than to creditors.
Second, the DRO would not apply to HHC if LCL liquidated and HHC had a
positive capital account following a liquidation of its interest in
LCL. Third, under the DRO, HHC’s obligation to restore was limited to
the amount of any deficit in its capital account. However, this amount
would not necessarily be the same amount as HHC’s proportionate share
of any unpaid debt owed by LCL.

When the Tax Court applied the Emershaw standard, no
comparison was made to Treas. Reg. § 1.752-2(b)(1), which is used to
determine a partner’s share of partnership liabilities for section
752. Under section 752, the regulations impose a “constructive
liquidation” test, which also entails a worst-case result in
determining a taxpayer’s basis with respect to partnership recourse
liabilities. Whether this comparison needs to be made in the future
remains an open argument.

For years, many practitioners have believed that a partnership or
operating agreement containing a qualified DRO would achieve some form
of at-risk status for the taxpayer. While the results of the Tax Court
in Hubert were not necessarily at-risk-friendly, they do
provide taxpayers with a road map of what a well-crafted DRO must
contain to render a taxpayer the payer of last resort.

The results of the 2016 presidential election are likely to have a big impact on federal tax policy in the coming years. Eddie Adkins, CPA, a partner in the Washington National Tax Office at Grant Thornton, discusses what parts of the ACA might survive the repeal of most of the law.